Pretax Contribution Definition

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Pretax Contribution Definition

What Is a Pretax Contribution?

A pretax contribution is one that is made to a specified pension plan, retirement account, or similar tax-deferred investment vehicle before federal and local taxes are deducted. For example, if you contribute $10,000 to a 401(k), you will not be taxed on that $10,000 of income in the year it is received. The government encourages you to save for retirement by making pretax payments.

Key Takeaways

  • A pretax donation is one that is made before any taxes on the amount are paid.
  • The purpose of pretax contributions is to encourage individuals to save for retirement.
  • Pretax contributions to retirement funds have the benefit of lowering your current-year income tax burden.

Understanding Pretax Contributions

Contributions to a retirement savings plan may be made either before or after taxes. If the donation is made using money that has already been taxed, it is referred to as an after-tax contribution.

Donations after tax may be made instead of or in addition to pre-tax contributions. Many investors prefer the idea of not having to pay taxes on their investment’s principle when they remove it. However, if tax rates are likely to rise in the future, after-tax donations make the most sense.

Individuals considering pretax or Roth contributions should compare their present tax rate to their predicted tax bracket in retirement. They should keep in mind, however, that tax regulations and rates vary over time.

Tax-Advantaged Accounts

A pre-tax donation is one made with money that has not yet been taxed. Traditional IRAs, 403(b), 457 plans, and most 401(k) plans are examples of tax-advantaged accounts that enable retirement planners to contribute annually before taxes.

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Employees may contribute to a retirement plan with earnings that are not subject to payroll or income taxes. When the employee withdraws money from the account, they just pay regular income tax on their contribution and profits. Furthermore, since pre-tax contributions lower the amount of taxable income and, as a result, income tax that an employee pays each year, an employee may afford to contribute more pre-tax than after-tax.

Consider an employee who makes $75,000 in gross income in a given tax year. If his effective tax rate is 24%, his tax burden for the year will be 0.24 x $75,000 = $18,000, leaving him with a take-home pay of $75,000 – $18,000 = $57,000. If the employee contributes $15,000 to their 401(k), their taxable income is lowered to $75,000 – $15,000 = $60,000, and their tax due is 0.24 x $60,000 = $14,400, which is less than $18,000.

As shown in this example, when computing a pre-tax contribution, the amount of taxes withheld is lowered as the basis for the taxable amount is reduced.

Fast Fact

Although pre-tax contributions minimize the amount of taxes paid at the time, deferring payments is always preferable owing to the time value of money.

After-Tax Contribution Plans

The Roth IRA, as opposed to pretax contribution options, is an after-tax contribution plan. While withdrawals from pre-tax contribution schemes are taxed, Roth contributions are now taxed, but their profits may be taken tax-free.

When deciding whether to make pretax or Roth contributions to a retirement plan, a person should compare their present tax bracket to their projected tax bracket in retirement. Their tax bracket upon retirement will be determined by their taxable income and the current tax rates. Pre-tax contributions are anticipated to be more favorable if the tax rate is predicted to be lower. If the estimated tax rate is greater, the person may be better off with a Roth IRA.

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Making pre-tax donations benefits people who qualify by lowering the amount of taxes paid at the time. After all, deferring payments is usually preferable owing to the time worth of money.

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